Wednesday, March 11, 2009

Risk and Return

In a recent paper by Nassim Taleb, and indeed many many more articles now, the claim is made that if the quants/risk-managers knew the pitfalls of their risk modeling methods, the catastrophic losses made today could have been avoided. Sure.

Here's the thing. Itis precisely because they disregarded the risks that they made all the money they made over the decade leading upto the catastrophe. So if they had actually factored in the risks, they'd have taken much more conservative bets and thus they'd have made much less money and therefore a smaller bad move could have wiped out what they have made. This argument could probably continue to be made until the average annual return generated by financial firms would be in direct proportion to their actual equity and real GDP growth in the economy. No?